Market Analysis: So, What is Strike Three? Is This Rally for Real?

The markets have a tendency to repeat patterns. If you review past markets, you can clearly see these patterns. The question remains: are we repeating the pattern of 2007, when the first correction lasted 5 months and resulted in a drop in equities of 19%? Or, are we repeating the pattern of 2010, when the correction lasted roughly 4 months, and the market dropped 19%? Time will tell, but we should know the result by year end. As a review, after the first correction in 2007-2008, the market had a nice rally of 12% that lasted about 2 months. Following the rally, we started to sell off, thus confirming a bear market. We all remember how badly 2008 ended.

In 2010, after the market dropped 19%, the Federal Reserve stepped in and announced “quantitative easing.” This provided a lot of liquidity to markets, and equities took off for a rally of over 25%. There is some discussion that the powers that be in Europe are considering a $2Billion fund to support the banking system/economy in Europe. That would most likely cause more upside in the markets. It could have a similar effect as the Fed’s actions last year. Will it “fix the system”? It is doubtful. Last night I read an article indicating that Standard and Poor’s is considering dropping the credit rating on 5 European countries (that is not good).

At IAP, we believe that the economy is showing signs of turning back down. Risk management is key to protecting wealth. If the market stalls in the next month or so, we will reduce risk in equities. One way of reducing risk is holding a stock like McDonald’s vs. a stock like Google. Other ways to reduce risk include reducing your overall exposure to equities and adding more fixed income. During the next few months, the market should give us a good feel on how 2012 will be for investors. Obviously the election is on the way, and it still appears there are a lot of unanswered questions regarding this economy.

For those of you who enjoy watching and reading articles about the stock market, there are some milestones for which you may want to watch. Today you hear a lot about a “trading range”; if you listen to CNBC or read the Wall Street Journal, you will hear discussions about “the market is in a trading range”. A trading range is when you have a lot of volatility like we are seeing now. The market bounces up and down.　 Today, the “macro” trading range is 1100-1280 on the SP 500; that is equivalent to about 10,400 – 12,000 on the DOW.　 We felt in September that the market would get below 1100 on the S&P 500 and below 10,200 on the DOW. We were close, as the market did go to 1075 and 10,400. The upside range of this “trading range” is 1280 (SP 500) and 12,000 (Dow). So if the market can break above these levels to the upside and hold, it would be a good sign for the market as the trading range has been “cleared”. For those that follow technical analysis, the actual 200-day moving average is 1275 on the SP 500. History has shown us that when the markets are below the 200-day moving average, risk management needs to be a serious consideration. If the market stalls there, caution would be warranted, and reducing risk would be prudent. Strike three, or a bear market confirmation, would occur if the market falls back to the bottom of the trading range and break the last low…DOW 10,400. So in conclusion, we would like to see the market break to the upside here, and hold the 200-day moving average.